India’s current account deficit has risen substantially and there is downward pressure on the exchange rate, with unchecked fiscal spending during the expansion period leaving authorities with little room for manoeuvre in the ongoing slowdown, says the Organisation for Economic Cooperation and Development (OECD) Economic Outlook released on Tuesday. With investments in India’s stock markets being affected, the report said that government subsidies and other off-budgetary spending be “made available only to those in real need”.

The report notes that official figures on government spending show impressive deficit reductions at both the central and state levels since the introduction of the Fiscal Responsibility and Budget Management Act (FRBMA). However, off-budget spending and unfunded commitments have risen. Pay Commission increases for public sector employees and loan waivers for small farmers introduced in the last budget look set to add an additional 1 per cent of GDP to the fiscal deficit in 2008 and more to the deficits of state governments, according to the OECD. The government has so far only committed to reimburse the banks one-third of the cost of the loan waivers.

While the loss of confidence on the part of international investors is linked to a global flight towards the safest assets, the OECD lamented the serious loss of fiscal discipline that has led some credit agencies to downgrade India’s sovereign debt. “As debt issuance increases, the risk premium on Indian paper could rise, further depressing stock market prices,” the report warns. “This could trigger additional withdrawals of foreign equity from the markets and apply downward pressure on the exchange rate.”

India’s current account deficit widened to 2 per cent of GDP in the first half of 2008, against only 0.5 per cent a year earlier, according to the Centre for Monitoring the Indian Economy (CMIE). The only silver lining has been that the inflation seems to have eased thanks to the sharp decline in prices of metals and petroleum. “Going forward, all indicators of inflation are expected to ease, in a context of lower commodity prices and slower growth,” the report said.

However, pressure on the exchange rate against the dollar, and a negative swing in portfolio investment to the tune of 6 per cent of GDP in the year to second quarter of 2008, are cause for worry, says the report.

Equity prices on the stock market by end-October were 53 per cent below their January 2008 peak. This, despite the Reserve Bank reducing the cash reserve ratio for banks by 350 basis points to 5.5 per cent, and repo rate by 150 basis points to 7.5 per cent.

The report predicts that growth is likely to be more subdued this year and the next, till late 2009 when global financial markets make a gradual return to normal conditions.

“But pressure on the currency (rupee) may limit the room for further cuts in interest rates, so that the real rates facing consumers and firms will rise. This can negatively impact domestic demand,” the report said.

Overall, the OECD projects growth to drop to around 7 per cent in 2008 and 2009 before recovering to over 8 per cent in 2010 as world growth picks up.

On the upside, however, the likely decline in inflation could help restore investor confidence more rapidly than envisaged, which would support demand and activity, the report adds.
 

Klaus Schmidt-Hebbel, OECD’s chief economist, added that the financial turmoil that erupted in the US around mid-2007 has broadened to include non-banking financial institutions and rapidly spread to the rest of the world. The recovery will be anaemic as mortgage delinquencies rise further. “Following the collapse of Lehman Brothers in mid-September, a generalised loss of confidence between financial institutions has triggered reactions akin to a ‘blackout’ in global financial markets,” he noted.

The OECD notes that dominant downside risks for 2009 include a longer than assumed period before financial conditions normalise, further failures of financial institutions, and the possibility that emerging market economies like Brazil, Russia, India and China (BRIC) will be hit harder by the downturn in global trade and foreign investor risk reassessments.

The report calls for further reform of financial market supervision and regulation to build a more resilient financial system, primarily by strengthening and streamlining the oversight of financial and capital markets, and plugging gaps and inconsistencies in different regulatory regimes.

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